Is Islamic Finance ascending over the decline of Western Banking?

There is little wonder that the Islamic finance is being increasingly utilised by non-Islamic and Muslim organisations alike. But is it a case of Islamic versus Western Banking? While such comparisons are inevitable, the reality is not that simple.

Islamic banking forbids speculative investing, or the payment or collection of interest, and prohibits investments that are unjust to participants, or are involved in the prohibited – haram – businesses such as gambling, alcohol, pornography and the sale of certain foodstuffs. Indeed, as it stands, Islamic banking industry assets are growing twice as fast as those of conventional banks, and are estimated to reach US$1.1 trillion (QR4 trillion) by the end of 2012, up 33 percent from 2010, according to a recent report by Ernst & Young.

In the same positive vein, the Islamic finance industry as a whole has grown in size from around US$10 billion (QR36.4 billion) of total invested assets in 1975 to just over US$2.2 trillion (QR8 trillion) at present, according to figures from 1st Ethical a charitable trust in London, that provides Shari’ah-compliant financial advice. The key questions here are whether this trend will broadly continue, and what changes can be expected in global Shari’ah investments?

Islamic Finance Fills The Gap

It is reasonable conjecture that if this concept of sharing risk and reward alike had underpinned the conventional investment banking market, then the new global ‘casino’ banking that emerged in the United States (US) and Europe in the early 1980s would not have over-extended credit, at least not to the degree that fuelled the sub-prime housing crisis in the first place, underlines Sam Barden, chief executive officer (CEO) of SBI Markets in Dubai.

“Local bank managers in the US and the United Kingdom (UK) used to know who their customers were on a personal basis,” he says, “and they regarded the bank’s depositor money as being their personal responsibility. Can you imagine anyone in that position lending 120 percent or more of the purchase price of a house to somebody who doesn’t have a job, and possibly even no shoes? But that’s exactly what happened…in the run-up to 2007.”

Compounding this was over-extended credit from the base of society, permeated through the rest of the financial system and found its apotheosis in collateralised debt obligations (CDOs). CDOs were, and remain, lots of fundamentally worthless pieces of credit cleverly bound up through the alchemy of financial mathematics into AAA-rated credit structures. Unfortunately for everyone, these then wound up on the balance sheets of the world’s major financial institutions and corporations. And then, after 9 August of 2007 – when French bank BNP Paribas stated that it would not be able to retrieve money from two of its funds due to “the complete evaporation of liquidity in the market” – it started to become worryingly clear that even major banks around the globe did not trust each other’s ability to pay back each other’s liabilities, and from that point the confidence in the whole system had collapsed.

Therefore it certainly seems that Islamic finance has increasingly filled the gap left in the global banking market that emerged, post-financial crisis 2008 as conventional banks moved away from their most basic banking model. This involved taking in deposits and then lending them out again to individuals and businesses, based on the specific knowledge of a bank about said individual or business (much in the same way as many Islamic banks still operate). For decades, in the US and the UK this was the main method of banking, until those at the top of the industry decided that taking some of these customer deposits and investing them on behalf of the bank – by itself and for itself alone – would generate greater incremental returns.

Thus, investment banking (or ‘casino banking’) was born. Islamic banking was Shari’ah-bound not to follow this route, highlighting a fundamental ethical difference between the two.

Nevertheless it is true, underlines Khairul Nizam, assistant secretary general of the Accounting Auditing Organisation for Islamic Financial Institutions (AAOIFI), in Bahrain, there is nothing to preclude the ultimate financial results or effects of a Shari’ah-compliant banking product being exactly the same as those of a conventional one.

However, Nizam adds: “The key consideration in this respect is that although the financial effects of, say, an Ijara contract may be identical as those of conventional leasing, mortgage or loans, whether it is Shari’ah-compliant or not depends on how such a product is structured.”

A key point in terms of the psychology of the business approach (and, morality, some might say), is that an Islamic banking or financial product which may be structurally similar to the speculative punts in Western banking must, by definition, still be based on the concept of partnership, which involves the sharing of risk and reward equally.

Reform vs. Pressure

Having said this, in the Western banking realm, pervasive public paranoia about ongoing counterparty credit risk issues, spectacular trading losses, and sleazy financial scandals sparked the mandate from the 2009 G20 meeting in Pittsburgh. This was broadly aimed at enhancing trade transparency and central clearing for all major financial asset classes in conventional banking. Perhaps the most noticeable key impact of this brave new financial world for treasuries everywhere will be on capital and margining requirements for trading, both of which are set to dramatically increase, and the regulation of which will be much tighter in both the US, and Europe, for example.

For its part, in a similar move to segregate assets, Qatari commercial banks were also required in December last year to transfer accounts from their Islamic divisions into a portfolio to be held by the Central Bank until they mature, under a rule separating the two kinds of finance. “These will be carried in a portfolio, outside the activity of their business,” said Qatar Central Bank governor Sheikh Abdullah bin Saud Al Thani at the time, “as we are not in the business of mixing the Islamic with the non-Islamic.”

This followed a central bank directive in February of that year to stop commercial lenders from taking new Islamic deposits immediately, and shutting Islamic branches by year-end due to concerns they may be using funds from the conventional bank for Islamic loans.

This tighter regulatory regime for conventional banking and finance – if stringently enforced – would return Western financial institutions more into the market niche occupied solely for a long time by their Islamic counterparts. Interestingly here, despite their virtual monopoly position in this financial segment for years, Islamic banks have in many ways failed to fully capitalise on their advantage. To begin with there has sometimes been a blurring of the Shari’ah code: at around the same time as the conventional financial system was going into full crisis mode – 2008 – the AAOIFI stated in February of that year that the repurchase undertakings found in many apparently Shari’ah-compliant bond structures violated the Islamic duty to share risk, particularly in ‘mudaraba’- and ‘musharaba’-based sukuks (see below).

Bernard Barbour, head of legal and Shari’ah affairs for QInvest, in Doha feels that there is an issue exacerbating the difficulty for investors in assessing the relative Shari’ah-compliance of these two vehicles and other related products. And that is although most Islamic market participants are aware that sukuk should grant the investor a share of an asset or business venture (along with the cashflows and risk commensurate with such ownership), many sukuk structures in the past in reality had more in common with conventional debt instruments from a risk/return perspective.

In this context, the latter usually represents non-asset backed interest-based funding for general corporate purposes (see box out). Indeed, Barbour adds, as a result of attempting to seek greater profits, and of a lack of innovation in Shari’ah/legal structuring, and of the fact that some Islamic banking products are still mirroring conventional products in all aspects, there was a drift by some supposedly Islamic banks more towards conventional banking offerings, albeit under the guise of Islamic finance.

As a result, he says, since 2008 there have been at least 20 defaults on sukuk in the last five years from Malaysia and the Gulf Cooperation Council (GCC) countries, due to the lack of true Shari’ah-compliance of these products. “In the run-up to 2008 the exceptions to the rule of Shari’ah-compliant products became the rule, and for Islamic banking to move forward it needs to go back to the book and focus on doing the basics of Islamic banking properly,” furthers Barbour.

SHARIAH MUDARABA AND MUSHARAKA INVESTMENTS

In ‘mudaraba’-type investments an investor provides capital to an entrepreneur for an investment activity, and the ‘profits’ (notionally, cashflows generated from underlying assets) are shared at a pre-agreed ratio while the losses are borne by the investors alone, although many Shari’ah scholars maintain that any risk should be shared out equally. Meanwhile, in ‘musharaka’-type instruments, all partners in the joint venture are entitled to a share in the profits at a mutually agreed ratio (with excess income taken as an ‘incentive fee’), and losses are shared out in proportion to the amount invested.

SHARI’AH NON-COMPLIANCE?

The AAOIFI, at the time of publishing its six guiding principles relating to true sukuk structures, posited that 85 percent of the supposedly Islamic bonds (excluding Ijara-type sukuk) in circulation at that point were not in compliance with Shari’ah ideals at all. The organisation maintains that investors in genuine asset-backed sukuks should have rights over the bond’s assets, that they should be sold legally, and that the originating company should transfer these assets at the outset to the investors. The logical extension of this approach, then, would be that, even if the sukuk originator were to default and go bankrupt, then investors in the bond should be in a good position to recover much of their investment, depending on the quality of the underlying asset.

The key to challenging a newer and improved conventional banking system in the West, says AT Kearney’s Cyril Garbois, head of Middle East Financial Institutions Practice, in Dubai, comes down to two basic choices for Islamic banking. The first is to more fully exploit the Shari’ah-compliant niche, while the second is to compete with conventional banks head on.

In terms of the former, he underlines, it is vital to target potential customers who care most deeply about Shari’ah compliance in their financial dealings, as well as offering products and services that meet not only general financing but also Muslim-specific customer needs. In retail banking, target customer segments may include religious conservatives, muftis, awqaf employees, or employees of ministries of Islamic affairs. A good example of a Muslim-specific retail banking product is financing for the pilgrimage to Mecca.

The latter approach, meanwhile, requires identifying customer segments least open to Islamic banking (for exclusion), those with needs not fully met in a Shari’ah-compliant manner (to address shortfalls), and those open to ethical banking to tap into a wider audience of both Muslims and non-Muslims.

Of, course, there can be scaled-up Islamic banks that attempt to straddle both strategies, with a notable recent example being the creation of a new ‘mega Islamic bank’ to be headquartered in Qatar. The memorandum of understanding for this new venture with a paid up capital of $US1 billion (QR3.6 billion) was signed in April between the Islamic Development Bank, Dallah Albaraka, and the Qatari government. “It will provide liquidity-management solutions in an effort to create an Islamic interbank market,” says Ahmad Mohamed Ali Al Madani, chairman of IDB, in Doha.

In broader banking terms, Islamic banks have witnessed asset growth rates surpassing their conventional peers in most markets. However, it is also the case that this outgrowth is waning in key geographic regions, including the Middle East, cites a recent report by AT Kearney Middle East. Additionally troubling is that this outperformance in asset-growth terms has not been matched in profitability, with several small Islamic banks in the GCC having struggled for years.

Nonetheless, the report underlines that overall banking penetration in many of the industry’s core markets is still low. For example, GCC countries have not yet achieved the banking penetration levels of countries such as France or the UK. Thus is theoretically ample room for growth for Islamic banking, given that it rarely exceeds a third of total market share, and that several potential markets with large Muslim populations remain largely untapped.